The Dangers of Fannie Mae Health Care

A public plan would have certain advantages. That's precisely the problem.

By

John E. Calfee

Updated June 26, 2009 12:01 a.m. ET

President Obama and most congressional Democrats say they want to preserve private health insurance. They also want to add a "public plan" to compete with private insurance plans. Their basic argument is that a public plan would offer needed competition, save money through low administrative costs and zero profits, realize greater economies of scale, and be a superior negotiator of the prices of medical services and technology.

ENLARGE

David Klein

The first three arguments are bogus. The fourth argument is only half-bogus -- but the half that isn't reveals a great danger: If a public plan is inserted into private insurance markets, the American health-care system could rapidly evolve into a single-payer system, which would have devastating effects on R&D for new medical technology.

The first argument, that we need a public plan to spur competition, just isn't plausible. Hundreds of health insurance plans already exist, and employer benefit managers can choose among numerous alternatives. There is no lack of firms willing to compete to provide health insurance.

As to the second argument, what is to be saved by avoiding profits? Nonprofit health insurance firms are common, including many of the Blue Cross-Blue Shield plans. Nonprofit status has not proved to be a reliable source of efficiency and cost-saving. The addition of new nonprofit cooperatives and the like -- as a bipartisan group of senators has proposed -- would make little difference, unless the new plans are given the power to set prices and take on extra risk supported by government subsidies.

Would a public plan have lower administrative costs? Well, how often are public enterprises run more efficiently than private ones? Why did practically all economically advanced nations dismantle their public airlines, phone companies, and so on, invariably obtaining lower administrative costs and consumer prices?

As Stanford University health economist Victor Fuchs has pointed out, what "insurance" firms actually sell to large employers -- which account for the single largest segment of the entire health-care market -- is usually administrative services, not actual insurance. (Large companies are not insured; they pay benefits directly.) There is no reason to expect a Medicare-like public plan to match the administrative efficiency of Aetna, Blue Cross-Blue Shield, Cigna, UnitedHealth Group, and WellPoint. Medicare doesn't even try. It outsources most administrative services to the private sector.

Turning to public plans like Medicare and Medicaid for more efficient administration is a fool's errand.

What about economies of scale? Aetna currently serves about 18 million subscribers, UnitedHealth Care serves between 25 million and 30 million, and WellPoint more than 35 million. That is more than is served by the health-care monopoly of Canada (population 33.6 million), and more than the entire health-care systems of most European nations. Once a plan reaches a few million subscribers, there may not be a lot of economies of scale left that can enable public plans to provide lower prices.

Finally, there is the crucial task of negotiating prices for doctors, hospitals, clinics, drugs, devices and thousands of other items essential to modern health care. Here, there are really two arguments for a public plan. The first is about bargaining skill and the firm size, basic ingredients in any negotiating environment.

There is no reason to think the administrators of a public plan will possess skills superior to those honed by private plan personnel during years of negotiations under the pressure of competition. Nor is there any reason to think that mere size would help.

True enough, relatively small European nations routinely obtain better drug prices than are achieved by mammoth American pharmacy benefit managers such as Express Scripts (50 million patients) and Medco (60 million patients), each of whose numbers exceed the entire citizenry of all but the largest European nations. Even sparsely populated New Zealand (population four million) gets better prices than the giant drug-price negotiators in the American private market.

Their success is due to what economists call "monopsony power." Monopsony occurs when a single buyer negotiates prices with several competing sellers (as opposed to monopoly, where there are many buyers but one seller).

Thus, if you want to sell your branded drug in New Zealand, your prices are negotiated with PharMac, a branch of the government. Much the same is true when selling to Canada, Germany, the Netherlands, and essentially the entire developed world save the United States. The negotiating power of these government entities results from monopsony, not superior skill.

For example, the various sellers of cholesterol drugs (Lipitor, Crestor, and so on) have to compete with one another while they all face a single government negotiator. If one seller balks at government prices, it leaves competitors to pick up more sales. The same is true for most other drug classes and most medical devices. This uneven battle ensures that negotiated prices will be well below those in a competitive market.

But here is where the huge risks of creating a "public plan" to compete with private insurance firms come into focus. Foremost among these risks are the effects of monopsony power in the purchase of medical technology.

The U.S. is unique because it alone is the source of half of world-wide profits that provide the payoff for the complex, lengthy, and expensive process of developing new treatments. When other nations construct their health-care systems, they ignore the impact of their pricing policies on R&D incentives. As the dominant R&D funding wellhead, we do not have that option.

Competitive markets have generated the prices and the profits necessary to induce a steady flow of medical innovation in this country. A public plan option would tend to dismantle that system. The people in charge will not know how to set reimbursement levels to motivate reasonable R&D efforts, and there is no reason to expect them to try. In public plans, the tried-and-true method is to push the prices of suppliers down until something gives -- too few doctors willing to take on Medicare patients, for example -- and then to ease up. That is a destructive approach to medical technology R&D.

Who knows what drugs will not be developed if reimbursement levels for a new multiple-sclerosis treatment are too measly? In virtually every advanced economy but our own, pricing authorities simply make sure prices are high enough so that existing drugs continue to be made available. We can expect a public plan here to do the same. The inevitable result is to drastically under-incentivize R&D.

This problem would not matter if a public plan remained small -- but it would likely grow into a monster. Monopsony negotiating power will generate lower prices, so many consumers will switch to a public plan. Employers eager to offload health-care costs will also dump unwilling employees into the public plan. That is the basis for the Lewin Group's much-cited prediction that a public plan would come to dominate any market in which it is allowed to compete.

Bargaining power, however, is far from the only potential source of below-market prices for public plans. In the home mortgage market, the public plans -- known as Fannie Mae and Freddie Mac -- were for years viewed by investors as less risky because they would be bailed out by the federal government if they took on too much risk. That translated into lower prices (the interest rates paid by borrowers), which eventually translated into extraordinary and unseemly growth, culminating in bankruptcy and a federal bailout.

The lesson for health insurance is clear. All insurance plans -- especially in health-care markets -- have to take on risk. Prudent planning, including the maintenance of reasonable financial reserves, is necessary. That increases costs. It would be all too easy for a public plan to gain a competitive advantage by taking on extra risk while keeping prices low because everyone would expect the federal government to take care of financial surprises down the road.

In sum, a public plan would possess formidable and perhaps overwhelming competitive advantages -- generated not by efficiency but by the artificial advantages of "public" status. This would have two disastrous consequences. The first will be to cause most Americans now covered by private insurance to move to public insurance -- one step away from single-payer health care. The second will be to undermine incentives to develop more of the immensely valuable medical technology that is central to all of health care.

Mr. Calfee is a resident scholar at the American Enterprise Institute.

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